Yield Pressure on U.S. Banks May Intensify

If the Fed goes from standing still to cutting rates, bank stocks will get crushed

The recent collapse in Treasury yields has been a bad development for banks. What comes next could be even worse.

Rates on Treasurys have fallen sharply over the past several days as traders have priced in a more dovish stance from the Federal Reserve and rising odds of a recession on the horizon. Bank stocks have been hit especially hard as a result. Since the Fed’s statement last Wednesday, the KBW Nasdaq Bank index has fallen 7.1%, compared with a 0.5% decline in the S&P 500.

Investors generally focus on the 10-year Treasury note as a benchmark and became especially concerned on Friday when this rate fell below the yield on three-month Treasury bills.

But bank specialists know that the 10-year yield isn’t particularly relevant to bank balance sheets as they have few assets with such long maturities. A typical bank likely has a mix of business and consumer loans tied to overnight rates such as Libor, some commercial real-estate loans with maturities of around five years and a book of securities with durations of around three to five years. Mortgages, the most long-term loan that banks issue, are typically sold off and securitized.

What should be of particular concern to bank investors, then, isn’t the 0.19 percentage-point fall in 10-year yields since Wednesday last week. Rather, it should be the 0.21 percentage-point decline in three-year Treasury yields, and 0.23 point decline in five-year yields. When medium-term securities or loans on bank books mature, they now will be rolled over into lower-yielding instruments.

What’s Next for Markets?

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The result is that net interest margins will stop expanding or even fall, ending a powerful trend that has boosted bank shares for years. Barclays analyst
Jason Goldberg
notes that bank net interest margins rose for three consecutive years from 2016 through 2018, the longest continuous stretch since the 1970s. That historic streak is likely over.

What would be especially punishing for banks now is if the Fed were to start cutting rates. That would pressure yields on even short-term loans, giving banks no place to hide.

Right now, Fed policy makers don’t see a rate cut on the horizon. Their median projection published last week calls for no rate increases this year and one next year. But markets, fearful of a coming recession, already are pricing in a 64% chance of one or more rate cuts by the end of 2019, according to
CME Group.

If that happens, bank shares have even further to fall.

Amid a shaky marketplace, investors are eyeing the yield curve for signs of economic stability. History shows that when the yield curve inverts, a recession may soon follow. Photo Composite: Stephanie Swart for The Wall Street Journal.